Financial Sector Odds

November 21, 2008

It’s a good thing email inboxes can’t make noise. If they could, mine would be screaming so loudly that nearby companies would complain.

“Where’s the darned rally?” would be the most commonly yelled question. “I thought markets were supposed to take a break after going in one direction for so long,” wrote one subscriber. “Don’t we just have to, have to, have to get at least a short-term bounce somewhere in here?” asked another.

Unfortunately, we don’t “have to get” anything, although I believe the odds are good for a short-term bounce. The odds have been good for a while, though, most recently at the former bottom that we bounced off twice before crashing through on Wednesday.

Still, let’s look at which way the odds say you should trade the financial sector at this juncture using ProShares leveraged funds. The 2x fund is UYG and the -2x fund is SKF. They’re among the market’s most active issues these days. Yesterday, UYG traded 290 million shares. Microsoft traded only 140 million.

Take a look at this chart:

Would you buy that thing? If the answer is no, because you see it’s (A) above an RSI of 70, (B) has an MACD almost off the chart, and (C) has gone parabolic, then you are bullish on the financial sector. That’s the SKF chart, the one that goes up as the financials go down. If you think that chart is dying to drop, then you think financials are dying to pop.

You would also think the 2x fund would give a corresponding signal that it’s ready to rise. Does it? Have a look:

There’s ugly, and there’s ugly, and I think we just found the latter. If charts were dates, that one wouldn’t be dancing with anybody at the Wall Street Ball.

In its defense, it’ll soon be easing the pain or feeling no pain. The bottom of the chartable area, which is to say zero, isn’t far now.

Which brings up an interesting point. Can a leveraged index ETF hit zero?

No, but it can feel like it. When the Nasdaq lost 78% in the dot com bust, 2x vehicles lost around 98%. ETFs don’t go to zero, but they can get close. Take any number and keep subtracting 5% from it forever and you’ll never hit zero. Once an ETF gets close to zero, its management company would likely run a reverse split to get it trading at a reasonable level again. For instance, if it gets down to $1 and you own 5,000 shares, after a 1-5 split you’d own 1,000 shares valued at $5 each. Fun.

Back to the two charts. Both are giving point-and-figure sell signals at the same time, providing you with the market’s version of damned if you do and damned if you don’t. The rationale for SKF’s P&F; sell signal is “Long tail up on Nov. 18.” For UYG, it’s “Descending triple bottom breakdown on Nov. 18.”

Where are the odds? With UYG. It’s due for a bounce and SKF is due for a drop. If overseas markets are any indication, we may get that bounce today. Japan rose 2.7% and London is up 1% as of 5:00 a.m. Wall Street time.

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